European governments could simultaneously reduce income tax, increase innovation and cut pollution by introducing well-targeted environmental taxes and recycling the revenues back into the economy. This was one of the findings from a pair of reports on environmental tax reform (ETR) published today by the European Environment Agency (EEA).

Environmental tax reform is defined as 'reform of the national tax system where there is a shift of the burden of taxes, for example from labour to environmentally damaging activities, such as unsustainable resource use or pollution'.

There are at least four possible types of effects of ETR. The first effect is to make various goods or activities more expensive, while the second effect comes from the direct or indirect distribution of this extra revenue. Thirdly, job creation and eco-innovation may be another result of this process. And lastly, effective ETR will also result in environmental benefits, for example by reducing pollution.

Environmental taxation also has an important role to play in spurring innovation, according to a broad range of studies. By increasing tax on pollution and other environmentally-damaging activities, governments can use the extra funds to provide incentives for innovation, such as developing renewable energy. For advanced economies like the EU, such schemes also create new technologies which can be exported globally, the reports say.

The reports also look at ETR in practice across Europe. Analysis of policies in Germany and the Netherlands showed that ETR and other environmental policy instruments have broadly positive effects in increasing innovation. The wider economic effects of ETR have also been analysed in Germany, where environmental taxation cut pension contributions and created an estimated 250 000 jobs.

One of the challenges of ETR is ensuring the costs and benefits are appropriately distributed across society, and do not negatively impact the poorest people. Instruments also need to balance the right mix of environmental and economic incentives. Ultimately, ETR mechanisms can only be implemented if they are acceptable to the public and policy-makers.

Modelling the impact of environmental tax reform

The EEA calculated the impact of a tax on energy and other resources, with the revenues used to cut social security payments and income taxes. The model indicated that this fiscal reform would result in financial benefits for almost all socio-economic groups. However, in a few countries the poorest people could see negative effects, as these people spend a higher proportion of their income on energy.

Increasing the cost of emitting carbon could also have a negative effect on the poorest groups, according to a Germany-based modelling study. However, the scenario shows that the worst-hit parts of society could lose just 1 % of their disposable income in 2020, so it would be relatively simple and affordable to compensate the affected groups via targeted benefit transfers.

Furthermore, the reduction in social security payments means labour costs decrease, boosting employment – the model suggests that increasing the price of emitting one tonne of carbon dioxide to €68 by 2020 could create 152 000 additional jobs in Germany.

The modelling exercise also analysed the effects of applying ETR to meet the EU target of reducing greenhouse gases by 20 % by 2020. This scenario looked at the effect of taxing emissions, with the revenues used to support innovation and reduce income tax and social security costs. The model showed that the policies would increase employment by more than 1 million jobs, with only a small (0.04 %) cost to GDP to achieve the 20% GHG reduction target at EU level.